Going for Goldman

There's been a lot of indignant chatter about how Goldman Sachs had been selling investors long positions that they were short on, and how this represented a conflict of interest, or something. This rather fundamentally misunderstood the role of a market maker, which is, after all, to take the other side of the trade.

On the other hand, if the SEC complaint filed today holds up, these complaints will turn out to have a certain . . . truthyness . . . to them:

The hedge fund, Paulson &Co., paid Goldman $15 million to create the CDO in early 2007, when the U.S. housing market and related securities were beginning to show signs of distress, the SEC complaint said.

According to the SEC, Goldman Sachs failed to disclose that Paulson played a significant role in selecting the CDO's portfolio, but the firm then bet against it by entering into a credit-default-swap transaction with Goldman to buy protection on certain layers.

As a result of that bet, Paulson made about $1 billion, SEC said.

"Goldman wrongly permitted a client that was betting against the mortgage market to heavily influence which mortgage securities to include in an investment portfolio, while telling other investors that the securities were selected by an independent, objective third party," said Robert Khuzami, Director of the SEC's Division of Enforcement.

One wants to be cautious about saying that Goldman Sachs is definitely guilty. Financial crises produce immense political pressure for securities regulators and attorneys general to go head-hunting, and the cases often turn out to be weaker than they seem once the defense gets a chance to speak. The case against two Bear Stearns hedge fund managers, for example, turned out to hinge on horrific-sounding quotes that had very clearly been ripped out of a context that totally changed the implications. Which just goes to show how heavy the pressure is on prosecutors to make these cases.

But it certainly sounds as if the SEC has the goods here. Felix Salmon has gone through the pitchbook, and pronounces it free of any indication that a third party with a strong economic interest in the transaction was picking the securities to be included. I will be interested to hear the defense rebuttal. It should, at the very least, be entertaining.

Was anyone hurt by it? That's less clear--at that point, the market still had a bit of froth left, and people might well have bought the securities if Paulson's interest had been disclosed. But that doesn't matter. It's hard to imagine anyone making an argument that Goldman didn't have an obligation to disclose this information--and the fact that they failed to disclose seems to indicate that Goldman, at least, thought that the information would adversely impact the sale price.

I suspect this case will get a lot of public traction. At this point, what galls people is not so much the stupid behavior that led to the bailouts, but the blatant self-dealing that seems to have gone on. Unfortnately, much of that self-dealing is not actually illegal . . . so when we find an example that is legally actionable, the public and the court system are bound to jump on it with both feet.